Good Debt; Bad Debt

I often hear the goal of a business owner as “I want to pay off my debt.” When questioned more closely the source of this goal is the frustration and perceived risk of having debt and the debt payments. The idea that the owner would make more money if he didn’t have the debt is a little illusory—the debt also helped build the businesses. What is good debt? There are two criteria in answering this question—the type of debt and the use of he debt. Is owning a home a good thing? Of course and few of us would own homes if we had to save the money and pay cash, but would it be a good thing to put the purchase of your home on a credit card? Long-term assets need to be purchased with long-term debt. The converse is also true—don’t pay off your credit card with a home mortgage. Short-term assets need to be purchased with short-term debt. So the first criteria is to match the type of debt to the type of purchase. The second (and probably more important criteria) is the use of the debt funds. A good use of debt in a business is to finance growth (inventory, cash flow, etc.) and to purchase assets that produce income in excess of their cost. Obviously we don’t want to use debt to purchase non-income producing assets (like toys) for a business. Be careful about using debt as a tax plan. Businesses that run their business with the objective of minimizing taxes are missing the point—the business needs to be run for a profit. Of course all debt—even good debt—brings with it risk. One reason the owner gets the big bucks is to make the decisions that balance the use of the debt with the risk.